Markets Insight
February 12, 2013 8:23 pm
Give stocks a tax break to end bonds bias
Low level of yields reflects fiscal and regulatory imbalance
Cast an eye around the credit markets and it is hard not to conclude that risk is being mispriced. The compression of spreads and near zero policy rates of interest have contributed to a marked decline in yields. This has recently been especially sharp in corporate high yielding paper and junk bonds, reflecting the growing desperation of income-hungry financial institutions in a phenomenally low yielding world. The question is whether this manic buying, which smacks of the period before the credit crunch in 2007, constitutes a systemic threat.
At first glance there appears little cause for concern, given that developed world economies are aeons away from overheating and that the associated costs of any mispricing may merely amount to a misallocation of resources rather than a systemic crisis. Yet the Institute of International Finance, in its latest Capital Markets Monitor, argues that the question of mispricing is particularly applicable in the eurozone where economic divergence between stronger core countries and the periphery appears not to have gone away. Since economic divergence has been one of the main causes of tensions within the monetary union, its persistence despite improvements in current accounts and unit labour costs raises the question of whether the sovereign debt crisis is really over.
Note, too, that the mispricing of credit risk stores up trouble for later. An interest rate shock following a market reassessment of sovereign risk or an end to central banks’ asset buying programmes might wreak havoc among leveraged institutions. Looked at from a structural perspective, the extraordinarily low level of bond yields also reflects an unhealthy fiscal and regulatory bias against equity.
In most jurisdictions interest payments are tax-allowable, whereas dividends are not. Since the financial crisis regulators have strengthened the pro-bond bias by introducing risk-mitigation rules that favour low-risk, fixed interest bonds in banking, insurance and pension funds. In some countries financial stability has taken priority over making finance available to the real economy.
At the same time, global imbalances tilt the system in favour of low-risk investments because of the huge accumulation of official reserves in high-saving countries with big trade surpluses. These are traditionally invested in highly liquid government and agency paper.
Sovereign wealth funds are a potentially more benign recycling vehicle for these savings surpluses since they have a mandate to aim for higher returns. Yet their role in fiscal stabilisation since the onset of the financial crisis has forced them into lower risk mode. Most important of all, ageing constitutes a serious headwind for equity markets since older investors move funds out of equities into lower-risk fixed interest securities and bank deposits. This is already a reality in Japan and across much of the developed world.
A new report from the Group of Thirty, which represents the great and good of global finance, argues that this is one of several potential constraints on the long term investment that will be required to expand the productive capacity of modern economies.* On the basis of a range of growth forecasts and investment projections it estimates that nine leading economies that spent $11.7tn on long term investment in 2010 will need annual investment of $18.8tn in real terms by 2020 to achieve even moderate levels of economic growth. The economies concerned account collectively for 60 per cent of global gross domestic product.
The report provides an eloquent tour d’horizon of the factors that inhibit long-term financing in the public and private sectors, ranging from bank deleveraging to fiscal consolidation. It highlights, among a variety of policy recommendations, the scope for increasing the size of corporate bond markets in both the developed and developing world, while calling for the regulatory and fiscal handicaps on equity financing to be addressed.
This is not an easy agenda in the aftermath of the financial crisis. Yet the authors rightly say that it is important to review the regulatory framework to ensure that reforms aimed at increasing the safety of the financial system are fully supportive of economic growth, investment and job creation. In the advanced economies long-term investment is particularly important because it is one of the few ways of boosting economic growth during a time of deleveraging and necessary fiscal consolidation.
Addressing the anti-equity fiscal bias runs into the intractable difficulty that any change would create winners and losers. This could be overcome, the report suggests, by a revenue-neutral initiative to eliminate the tax deductibility of interest payments at the same time as lowering the marginal tax rate for companies.
Or tax deductibility could be applied to equity dividends while increasing the marginal tax rate. It calls for international discussion on the issue.
The logic of these proposals is compelling. The difficulty lies in the politics.
*Long-Term Finance and Economic Growth
The writer is a Financial Times columnist
.
At first glance there appears little cause for concern, given that developed world economies are aeons away from overheating and that the associated costs of any mispricing may merely amount to a misallocation of resources rather than a systemic crisis. Yet the Institute of International Finance, in its latest Capital Markets Monitor, argues that the question of mispricing is particularly applicable in the eurozone where economic divergence between stronger core countries and the periphery appears not to have gone away. Since economic divergence has been one of the main causes of tensions within the monetary union, its persistence despite improvements in current accounts and unit labour costs raises the question of whether the sovereign debt crisis is really over.
Note, too, that the mispricing of credit risk stores up trouble for later. An interest rate shock following a market reassessment of sovereign risk or an end to central banks’ asset buying programmes might wreak havoc among leveraged institutions. Looked at from a structural perspective, the extraordinarily low level of bond yields also reflects an unhealthy fiscal and regulatory bias against equity.
In most jurisdictions interest payments are tax-allowable, whereas dividends are not. Since the financial crisis regulators have strengthened the pro-bond bias by introducing risk-mitigation rules that favour low-risk, fixed interest bonds in banking, insurance and pension funds. In some countries financial stability has taken priority over making finance available to the real economy.
At the same time, global imbalances tilt the system in favour of low-risk investments because of the huge accumulation of official reserves in high-saving countries with big trade surpluses. These are traditionally invested in highly liquid government and agency paper.
Sovereign wealth funds are a potentially more benign recycling vehicle for these savings surpluses since they have a mandate to aim for higher returns. Yet their role in fiscal stabilisation since the onset of the financial crisis has forced them into lower risk mode. Most important of all, ageing constitutes a serious headwind for equity markets since older investors move funds out of equities into lower-risk fixed interest securities and bank deposits. This is already a reality in Japan and across much of the developed world.
A new report from the Group of Thirty, which represents the great and good of global finance, argues that this is one of several potential constraints on the long term investment that will be required to expand the productive capacity of modern economies.* On the basis of a range of growth forecasts and investment projections it estimates that nine leading economies that spent $11.7tn on long term investment in 2010 will need annual investment of $18.8tn in real terms by 2020 to achieve even moderate levels of economic growth. The economies concerned account collectively for 60 per cent of global gross domestic product.
The report provides an eloquent tour d’horizon of the factors that inhibit long-term financing in the public and private sectors, ranging from bank deleveraging to fiscal consolidation. It highlights, among a variety of policy recommendations, the scope for increasing the size of corporate bond markets in both the developed and developing world, while calling for the regulatory and fiscal handicaps on equity financing to be addressed.
This is not an easy agenda in the aftermath of the financial crisis. Yet the authors rightly say that it is important to review the regulatory framework to ensure that reforms aimed at increasing the safety of the financial system are fully supportive of economic growth, investment and job creation. In the advanced economies long-term investment is particularly important because it is one of the few ways of boosting economic growth during a time of deleveraging and necessary fiscal consolidation.
Addressing the anti-equity fiscal bias runs into the intractable difficulty that any change would create winners and losers. This could be overcome, the report suggests, by a revenue-neutral initiative to eliminate the tax deductibility of interest payments at the same time as lowering the marginal tax rate for companies.
Or tax deductibility could be applied to equity dividends while increasing the marginal tax rate. It calls for international discussion on the issue.
The logic of these proposals is compelling. The difficulty lies in the politics.
*Long-Term Finance and Economic Growth
The writer is a Financial Times columnist
.
Copyright The Financial Times Limited 2013
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